Liquidity
While reading “What Goes Up” by Eric Weiner I noticed a repeated theme of the book, every crisis in market history has revolved around a so called “Liquidity Event”. Too much or too little, it all seems to fall back to liquidity.
The book is a history of Wall Street told by the participants and even though it was written back in 2005, it is still an interesting read because as you know, history repeats itself.
The crashes of ‘29, ‘87 and the internet bubble all had roots in liquidity. The Long Term Capital fiasco, liquidity or potential lack thereof. All comes back to liquidity.
I know it’s very simplistic but you have to remember, I like simple. I like common sense and understanding things on the most basic levels. I sleep better at night knowing that my investment decisions are based on the simplest of ideas.
Liquidity is the most basic, simple idea on the planet. It is the core of Economics101. Supply and demand. You have too much liquidity, prices go down, too little, they go up. The balance of the two is a challenge but it is understandable to almost everyone. As you well know by now, I believe you should only invest in ideas or businesses you understand. If you are wrong, you can live with it because you will understand how you failed. If you are right, you don’t need to explain your decision, you will just benefit from the decision. I am all about reducing complexity and increasing understanding and knowing that almost everything in business and investing for that matter revolves around liquidity, it just makes things easier.
Stock movements are a function of liquidity, always have been, always will be. If a stock has a tremendous amount of liquidity, the flows will always be there and help to generate the best market for a stock. During the ‘80’s and ‘90’s, liquidity in the equity markets were rarely a problem. The systems were designed to bring in market participants to offset demand and supply issues. The prices changed because the people who were involved were either more inclined or less inclined to buy or sell. Liquidity was there, it just might not have been there at that particular price.
As computers and algorithms took over, the liquidity changed and pricing changed. In 1995 if Fidelity wanted to sell 25 million shares of AOL they would go to a Goldman or a Soloman and ask for a bid. If they got one and liked it, the trade would happen. Fidelity would move on with that cash and buy something else. Goldman or Soloman would give the trade up to clients across the globe or take on the risk and sell it in the open market after the trade. They didn’t lose money often on these block trades and everyone was happy. Now, if Fidelity wanted to sell 25 million shares of let’s say Microsoft, it make take them all day and then some. There are no proprietary trading desks willing to take on the risk. The liquidity in the market is such that, yes, it will get done but the amount of time and the potential dollar risk is all on Fidelity. Is this a better system? Liquidity was available at both times but it acted differently.
That obviously, is an extreme example and times have totally changed. Every buyer and seller nowadays will put their order in some program that slices and dices the order all day. He knows that his order will be filled at the end of the day but is it liquidity? The only liquidity event is the closing print and over the years, this event has been fine tuned to such a point where it rarely creates a significant imbalance at the close.
An example: A customer wants to buy 300,000 shares of XYZ. Because of the lack of liquidity on all markets in this day and age, that order is put in a program that will perform some sort of execution of that order throughout the day. It may buy 30,000 shares from 9:30am to 3:58pm, leaving 270,000 to buy on the close to fill that order. In an unconnected world, that 270,000 to buy on the close would cause a very large price movement on that closing sale but since we have a world were competing forces are always around, some genius programmers have come up with programs that may mimic these orders up until 3:58pm and turn around and sell what they have bought and hopefully make a profit. In addition, most stocks are in some sort of index or ETF and those indexes and ETF need to balance or rebalance their portfolios incrementally and they do it on the close. Normally, they are counter to the imbalance because the activity during the day forces the index or ETF to refigure their allocation and that refiguring is what offsets the large imbalances. Thats liquidity at work. Same idea, different timing.
With some idea of liquidity in mind just think of some of the meme stocks we have seen in the last 15 months. These are all liquidity situations to the extreme. The vacuum on the way up is a confluence of over-demand and under-supply. The people that might want to have some sort of working order to sell a stock that comes into focus for the Reddit crowd will more than likely cancel their order and re-price it higher or cancel all together. Thus creating a vacuum. No sellers, 28,900 buyer’s, where do you think a stock is going to go. No liquidity, chaos ensues.
Does that make the Robinhood jockeys smart? Did they stick it to someone? Is every trader making a killing?
The answer is no to all of that. It is simple, they found a lack of liquidity and exploited it. It’s been going on for decades. The only thing that has changed is the speed at which this happens.
Remember, they treat the market like a casino and casinos were built for one reason and one reason only, to make money for the owners. You don’t get free drinks all night because the casino loves you, you get free drinks all night because as a gambler, alcohol fogs your decision making at critical times and thats what a casino wants. These apps that allow access and ease of trading are similar. They allow you access to a market with little or no liquidity and they let you run wild in that market. They are not doing it to democratize the equity markets, they are using it to make money off the order flow. The discovery of illiquid investments is not a new thing either. It’s just easier to find and to start the avalanche.
There is no going back I am afraid. Liquidity problems will continue to come up and that will be the talk of town for a while. The government will look into how to avoid the next liquidity crisis and a new one will pop up and history will continue to repeat itself.
One last note: Liquidity situations in equities are great for the front page but the bigger liquidity issues are with the banking industry. Stocks can gyrate and everyone bitches and complains but if the banking system freezes up, that is a real problem. As we look back on the last time the banks stopped lending in 2008-2009 we saw what that liquidity crisis did. The intervention by the Fed during that time was the only reason the whole planet didn’t crash and burn. They loosened the spigot and liquidity came back into the market.
It’s all about liquidity.